Monday, February 25, 2013

The Spin-Off Anomaly

The straightforward strategy of buying companies that have recently been spun off from their parent has generated very good results. Here's the performance of the Bloomberg Spin-Off index (BNSPIN Index) since 2003. As you can see, it's pretty good, a 15% annualized return vs a 6% for the S&P500 over that period. Volatility was higher but not extremely so (20% vs. 15%), while the beta was pretty close to 1.0.

Is this a crazy recent phenomenon? No. In 2003 McConnell and Ovtchinikov looked at 311 spinoffs undertaken by 267 parents between January 1965 and December 2000. On average, subsidiaries outperformed their benchmark companies by over 20% over the first three years following the spinoffs, with most of the excess returns within the first 12 months of trading. They found the parent company outperformed as well, but not by a robust amount.

I don't think there's a rational explanation for this. I remember at Moody's when they just spun off from Dunn &Bradstreet, it was really liberating. For years D&B had used the considerable Moody's cashflow to fund their dumb ideas to extend D&B, which really ran the executive board while Moody's made all the money. It was a classic waste of shareholder money, and so when the spin-off finally happened in 2000, Moody's (MCO) stopped burning its cash and investors reaped the windfall (32% return, annualized, from 2000-present). It's amazing how much money is wasted via such politics, but it's a classic case of a bad incentives and difficult monitoring.

It makes one wonder about the value potential in Citi (C). If someone could force it to sell itself into pieces, I bet everyone with defensible interests would hit a home run. Letting a $120B company underperform is really painful to behold. The only people such behemoths serve now are a select bunch of executives and politicians, not shareholders, consumers, or 99.99% of Citi employees.

7 comments:

Anonymous
said...

Did the companies that spun off subsidiaries underperform? My guess is no, i.e. they were holding the spin-off back with their bureaucracy. Esp. as an industry sector matures, I think companies do better with decentralized control.

Value investor Joel Greenblatt noted the relative high performance of spin-offs in his first book published in 1999. He attributed the high returns at least partially due to a depressed price for the new shares at time of spin-off. Typically, parent company shareholders were uninterested in the spin-off because it was in a substantially different from the parent's. So, they tended to dump the spin-off shares immediately.

Ahh…the forces of divestiture and conglomeratization eternally wrestling with each other like gravity and energy in the cosmos.

How about this for a rational explanation:Spin-offs generally result in more “pure play” stocks which then become more accurately valued in the marketplace. When the pre-spun-off business are tied up in larger companies, that component of the parent co. share price tends to be undervalued (due to uncertainty, lack of transparency, their tendency to be used to fund weaker siblings etc.) as opposed to fairly or overvalued – thus the outperformance of both parent and especially child post spin-off.

The arguments for mega-banks like Citi are the semi-mythical appeal of “one stop shopping” to the consumer and economies of scale in general which only foreign banks would have if we aren’t allowed to build our own monsters. The brokerage arms of mega-banks now rely more on their parent co.’s (zero interest) deposit base for capital instead of the bond market so I doubt much potential would be unlocked by a spin-off for that particular part of the business. Jefferies, the last decent sized broker/dealer not married up with a deposit taking institution, just tied the knot with Leucadia largely for this very reason. Citi has more or less the same model as the other mega-banks, they just happen to suck at executing on it so it’s possible that the sum of their parts is more valuable than the current configuration only because of bad management. But generally bigger banks like JPM have higher IRRs than smaller banks these days and probably the only advantage smaller banks now have is a capability for better, less formulaic underwriting and more accurate, hands-on risk assessment – but that’s not moving the needle much right now.

TBTF banks do have natural advantages over smaller banks (the compliance burden alone!) but we’re better off when most S&L type banking is utilitarian, boring and pretty tightly regulated (a view expressed by Taleb, parts of Dodd-Frank and certainly many others). I would argue that TBTF is simply too big because of the systemic risk and moral hazard issues that are inseparable from that model (a view certainly not expressed in Dodd-Frank).

Isn't it just aliasing a small/mid cap effect? You could overlay the SML or MID or other benchmark, but I think that the constant index rebalancing makes these poor comparative measures in any event. Moreover, I'd suggest that the spinoff universe/portfolio looks nothing like any of the benchmarks, i.e. it is dominated by companies with lower-betas and longer operating histories significantly longer than the avg mid or small index. It also has far less "binary companies" (biotech, technology etc.) and few financials which explains the index drag post-crisis.

Isn't the rational explanation exactly what you mentioned? That the better aligned incentives and morale boost after the spin off outweigh whatever synergies they had with the larger company had before the spin off?

The other explanation, mentioned above, that investors will generally sell spin offs which perhaps gives them a relatively low initial valuation also makes sense.